A Trump Catalyst For Value ETFs

With just a few weeks left in 2017, the following sounds like a broken record: Value stocks and exchange-traded funds are laggards. The S&P 500 Value Index is trailing the S&P 500 by more than 600 basis points on a year-to-date basis as growth and momentum stocks drive the broader market higher.

Successful implementation of President Donald Trump's tax reform efforts could be a positive catalyst for value ETFs, such as the iShares S&P 500 Value ETF IVE and the iShares Russell 1000 Value ETF IWD. The thesis is significant as many of the largest smart beta ETFs are value funds. Combined, IVE and IWD have about $55 billion in assets under management. The good news is value stocks really are offering, well, value.

“Many would argue that the discount is justified given a wide gap in earnings growth and profitability,” said BlackRock in a recent note. “Value stocks are, by definition, values for a reason, i.e. they tend to be less profitable. However, even after adjusting for current differentials in profitability, value looks cheap.”

Value Vindication

Spotting why value ETFs are attractively valued and potential beneficiaries of tax reform. A lot of that thesis revolves around the financial services sector, which is one of just a few sectors in a the U.S. seen as a credible value destination.

Financials are surging due in large part to the expectations of tax reform and the Trump administration's efforts to relax some of the regulatory burdens faced by the industry since the global financial crisis.

Financial services stocks account for over 28 percent of IVE's weight, more than double the ETF's second-largest sector allocation. The $40 billion IWD devotes almost 27 percent of its weight to financials, also more than double its second-largest sector exposure.

“Tax cuts might provide the missing ingredient,” said BlackRock. “The reason: Typically investors place a smaller discount on value when growth is faster, particularly nominal growth. In other words, a bit of inflation would help close the valuation gap between value and growth.”

An Inflation Assist

Investors waiting on ETFs such as IVE and IWD to become leaders should be rooting for higher inflation. Historical data confirm as much.

“Looking back at the past 20 plus years, value has traded higher relative to growth when inflation, measured by the consumer price index (CPI), is higher,” according to BlackRock. “Higher inflation would arguably be even more supportive if it were driven by higher oil prices, as energy companies appear particularly cheap today.”

IVE and IWD have an average weight to the energy sector of about 10.7 percent.

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